Fixed Income Outlook: How much longer can this movie play?

01-12-2018

The first year of the Trump administration, with all of its craziness, played out pretty much as we expected. Interest rates rose on average, led by the short end, albeit with a significant twist that kept the long end unchanged to slightly lower. To quantify that, the yield on the 10-year Treasury actually fell 4 basis points over the course of the year, while the yield-to-maturity on the broad Treasury Index rose 30 basis points. Yields relative to Treasuries, i.e., spreads, remained very constructive across all sub-asset classes—emerging market (EM), high yield, investment-grade corporate bonds, etc. These factors allowed us to generate significant alpha contribution from duration, sector allocation and security selection within our alpha pod process.

Muni fundamentals, technicals favorable; valuations a bit rich

An expanding U.S. economy is creating favorable municipal credit dynamics across most sectors. The exceptions to this trend are found in the hospital sector (where health reform remains a long-term risk) and the state general obligation sector (where credit quality has reached a plateau and some face difficult budget and pension trends). The final tax bill created fourth-quarter volatility as the elimination of tax-exempt advanced refunding deals prompted a rush of such financings, causing December to post a record monthly new issue total.

Going forward, we expect an offsetting decline in gross new issuance in the near term, and a longer-term decline in issuance as the loss of tax-exempt advance refundings should lower gross supply by about 20-25%. Demand for banks and insurance companies seems biased downward given the sharp decline in the corporate tax rate, while demand from individuals should remain stable as individual marginal rates fell to a much lesser degree. On net, given these favorable fundamentals and technicals, current valuations relative to Treasuries are somewhat rich, suggesting only incremental potential relative performance seems likely.

How does this play out going forward? We have been overweight credit for years, a strategy that has worked in a global environment of steady if unremarkable economic growth, continued monetary accommodation and low inflation. The question is, how much longer does this movie play? In virtually every sector, from EM and high yield to investment-grade credit, spreads have tightened below historical medians to pre-2008 lows. As 2018 gets underway, we are watching three factors outlined below to weigh when—more so than if—to possibly shift to neutral on credit. In fact, we made our first reduction the first week of the new year, dropping our high-yield overweight closer to near benchmark.

Inflation The lack of wage and price pressures arguably is the biggest surprise of this cycle, as key metrics of inflation have remained below the Fed’s 2% target even as unemployment has fallen to a 17-year low, annualized GDP growth has accelerated at its fastest pace in three years and global growth has turned solidly positive. There are signs that inflation may be inflecting higher—the New York Fed’s gauge of underlying inflation has shot up over the past year, December’s jobs report showed hourly earnings rising near a 2.7% annualized rate over the past six months and various commodity prices suggest upward momentum. But we’ve seen this episode before, only to see inflation fall back again. That said, there are reasons to believe that it’s more likely to break out this year, a bearish development for bonds.

Fiscal policy With tax reform now a reality, the question turns to just how big of a punch will it carry? Models vary, with the impact ranging from a small bump to as much as a 70- to 80-basis point addition to GDP growth. The concern is this stimulus would pile on an already expanding economy, adding to the potential for larger deficits (and debt issuance). Next up on the fiscal list are budget battles, starting this month with government funding set to run out; infrastructure—an issue that theoretically, at least, could draw some Democratic support even as it loses some GOP deficit hawks; and possibly entitlements. This last one is a remote possibility. Any real discussion of such is politically very difficult. But if it were to happen, it would be positive for all financial assets. On top of this, 2018 is almost certain to be politically combative, with crucial November midterm elections and infighting within the GOP threatening the Republicans’ hold on both houses of Congress.

Fed The choice of Jerome Powell to succeed Janet Yellen as Fed chair would seem to indicate a status-quo policy trajectory of gradual rate increases and balance sheet reduction, with a more pro regulatory-relief bias. While this path toward policy normalization is likely to remain subdued, it is a path toward higher rates nonetheless. Policymakers, at their December meeting, didn’t appear to be too worried about the trend of the yield curve getting even flatter and signaled three increases are likely this year, even though the futures market continues to price in only two. On top of this, the European Central Bank appears set to begin tapering and China is indicating that it doesn’t think U.S. Treasuries are very attractive. (A preemptive move against a possible trade war)? All of this argues for upward pressure on rates over the course of the year.

For now, our fixed-income models have the slightest overweight to high yield and a larger overweight to investment-grade corporate bonds, bolstered by the view that spreads still have a little room to tighten and the macroeconomic environment remains constructive. We also are slightly overweight on EM bonds, which are underpinned by strong investor demand and accelerating growth in Latin America, where the primary risk for 2018 will be elections in Brazil, Mexico and Colombia. Combined with a continued short bias on duration and a long-term strategic flattening bias on yield curve positioning, we believe opportunities for alpha still exist in the fixed-income world, although the movie could be nearing a plot twist. As always, stay tuned for any changes. Here’s to a happy and prosperous 2018.

Recent Fixed Income

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

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